Questioning a Chastened Priesthood
| Author | Jeremy Clift |
| Position | Editor-in-Chief of Finance & Development |
| Pages | 4-7 |
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Jeremy Clift profiles psychologist Daniel Kahneman
FOR Daniel Kahneman, one of the most moving episodes in the current global economic crisis took place when a humbled Alan Greenspan, the former chairman of the U.S. Federal Reserve, confessed before a congressional committee that he had put too much faith in the self-correcting power of free markets.
“He basically said that the framework within which we had been operating was false, and coming from Greenspan, that was impressive,” said Kahneman, who was awarded the Nobel Prize in Economics in 2002 for his pioneering work integrating aspects of psychological research into economic science.
But more to the point for Kahneman was how Greenspan, in his testimony, treated not only individuals but also financial institutions as rational agents. “That seemed to me to be ignoring not only psychology but also economics. He appeared to have a belief in the magic power of the market to discipline itself and yield good outcomes.”
Kahneman goes to great pains to stress that, as a psychologist, he is an outsider in the field of economics. But he helped lay the foundation for a new field of research, called behavioral economics, that challenged standard economic rational-choice theory to inject more realistic assumptions about human judgment and decision making.
Standard economic models assume that individuals will rationally try to maximize their benefits and minimize their costs. But, overturning some of the traditional tenets, behavioral economists show that people often make decisions based on guesses, emotion, intuition, and rules of thumb, rather than on cost-benefit analyses; that markets are plagued by herding behavior and groupthink; and that individual choices can frequently be affected by how prospective decisions are framed.
The global economic crisis, which had its roots in the decisions of individuals and financial institutions to invest in sub-prime mortgages, has put behavioral economics and the way humans make decisions in the spotlight.
“The people who took on subprime mortgages were thoroughly deluded,” says Kahneman during an interview with F&D at his house in the spectacular Berkeley hills overlooking San Francisco. “One of the main ideas in behavioral economics that is borrowed from psychology is the prevalence of overconfidence. People do things they have no business doing because they believe they’ll be successful.” Kahneman calls this “delusional optimism.”
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Delusional optimism, he says, is one of the forces that drive capitalism. Many people don’t understand the risks they are taking, says Kahneman—a theme echoed in a book by Nassim Taleb called The Black Swan (2007), which points out that people fail to take into adequate consideration the possible impact of rare but earth-shattering events that prove wrong their assumptions about the future.
“Entrepreneurs are people who take risks and, by and large, don’t know they are taking them,” he argues. “This happens with mergers and acquisitions, but it also happens at the level of small-scale entrepreneurs. In the United States, a third of small businesses fail within five years, but when you interview those people, they individually think they have between 80 percent and 100 percent chance of success. They just don’t know.”
Kahneman, who was raised initially in Paris and later in Palestine, was born in Tel Aviv in 1934. He says he is unsure if his vocation as a psychologist was a result of an early exposure to interesting gossip, or whether his interest in gossip was an indication of a budding vocation.
“Like many other Jews, I suppose, I grew up in a world that consisted exclusively of people and words, and most of the words were about people. Nature barely existed, and I never learned to identify flowers or to appreciate animals,” he said in his autobiography. “But the people my mother liked to talk about with her friends and with my father were fascinating in their complexity. Some people were better than others, but the best were far from perfect and no one was simply bad.” Most of her stories were touched by irony, he says, and they all had two sides or more.
An early event in Nazi-occupied Paris that he remembers vividly left a lasting impression because of varied shades of meaning and implications about human nature. “It must have been late 1941 or early 1942. Jews were required to wear the Star of David and to obey a 6 p.m. curfew. I had gone to play with a Christian friend and had stayed too late. I turned my brown sweater inside out to walk the few blocks home. As I was walking down an empty street, I saw a German soldier...
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